Most Popular

The Real Reason for the Global Financial Crisis…the Story No One’s Talking About

Stock-Markets / Credit Crisis 2008 Sep 18, 2008 - 03:44 PM GMT

By: Money_Morning

Shah Gilani writes: Are you shell-shocked? Are you wondering what's really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won't hear about it anywhere else because “they” can't tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can't tell you what's really going on because there's nothing they can do about it, except what they've been trying to do – add liquidity.

At the exchange rate yesterday (Wednesday), 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion Pound gorilla). According to the International Swaps and Derivatives Association , $62 trillion is the notional value of credit default swaps (CDS) out there, somewhere, in the market.

This isn't the first time Money Morning has warned readers about the dangers of credit default swaps. And it won't be the last.

The Genesis of a Derivative Boom

In the mid-1980s, upon arriving in New York from Chicago with an extensive background trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today's Citigroup Inc. ( C )]. The offer was for an entry-level post in the bank's brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”

I declined the position.

It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?

Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. ( JPM )] bankers devised credit default swaps.

A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
Typically, the insurance is for five years.

Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “ counterparty risk .”

If the party providing the insurance protection – once it has collected its upfront payment and premiums – doesn't have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt ( Bear Stearns was almost there, and American International Group Inc. ( AIG ) was almost there) the buyer is not covered – period. The premium payments are gone, as is the insurance against default.

Credit default swaps are not standardized instruments. In fact, they technically aren't true securities in the classic sense of the word in that they're not transparent, aren't traded on any exchange, aren't subject to present securities laws, and aren't regulated. They are, however, at risk – all $62 trillion (the best guess by the ISDA) of them.

Fundamentally, this kind of derivative serves a real purpose – as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.

What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you've been reading about), but didn't actually own the underlying credits, now had a means by which to speculate on them.

If you think XYZ Corp. is in trouble, and won't be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you'd essentially be speculating that the bonds would not default. You're hoping that you'll collect, and keep, all the premiums, and never have to pay off on the insurance. It's pure speculation.

Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I'm speculating on an event. I'm making a bet.

The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It's bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

What's even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn't, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

And this is only where the story begins.

The Ticking Time Bomb

What is happening in both the stock and credit markets is a direct result of what's playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG . Make no mistake about it, there's nothing wrong with AIG's insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn't have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there's more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.

[ Editor's Note : Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his new column, " Inside Wall Street ," Gilani promises to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street's most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential. If the whipsaw markets we're experiencing lead to the so-called market “Super Crash” that many analysts fear, shrewd investors won't have to worry. The reason: They will be able to capitalize on the once-in-a-lifetime profit plays that we detail in a new report. For a copy of that report – which includes a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, " Crash Proof: How to Profit from the Coming Economic Collapse " – please click here .]

News and Related Story Links:

• Wikipedia: Credit Default Swaps (CDS) .
• Money Morning News: JPMorgan Raises Bear Stearns Bid .
• Wikipedia : Over-the-Counter .
• Money Morning News Analysis: Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds .
• Wikipedia : Mortgage-Backed Securities .
• Web Site : International Swaps and Derivatives Association .
• Money Morning Market Analysis : Credit Default Swaps: A $50 Trillion Problem .
• Money Morning Market Analysis : Foreign Bondholders - and not the U.S. Mortgage Market - Drove the Fannie/Freddie Bailout .
• Wikipedia : London Interbank Offered Rate (LIBOR).

By Shah Gilani
Contributing Editor

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Comments

Rich Lancaster 23 Sep 08, 08:56	UST Repudiation Hey Shah. Presumably this entire mess will end with the Treasury repudiating US debt? Isn't it that simple. The real issue is: What happens after that. Cheers Rich
David Andorful 27 Oct 08, 04:12	global finance what is the role of financial scientist in the current global economy
Amber Smith 09 Mar 09, 21:52	why doesnt anyone care why is it that no one cares about other people this days. they just do things that suit them.
Leoxithre Evangel 24 Mar 09, 06:04	After that? Isn't it obvioous that our earth is depleting... Look around people... Try to solve this problem whatever we can... We need to think of what will happen next... I know I will...
Ally Wilbers 13 May 09, 00:54	truth-in-language Why is everyone calling it the Global Financial Crisis or Great Recession when it would be more helpful for the diagnosis and cure to call it Wall Street Mismanagement Fallout, =WSMF ? It's a dog's breakfast and the dog was not in Timbuktu!
05 Dec 09, 05:45	details Need more details.this article need more
Semin Sergei, Ph.D 04 May 10, 16:32	The Real Reason for the Global Financial Crisis The main reason for the current economic crisis is the inflation launched by the US government in order to finance the military operations in Iraq. According to various sources such costs amount to 700 million to 2 trillion dollars. The current crisis can only be overcome if the war in Iraq is finished. Inflation is the source for financing a war. The world governments have always supported ongoing wars at the expense of their own citizens and those of other countries. In the case of poorer nations, the internal markets collapse and the country’s economy practically becomes nationalized. Similar situation was experienced in Russia in 1917 (see: http://simon31.narod.ru/syndrome_of_socialism.html). The today’s fall of the US currency by 30% and the rise of the global prices for resources, fuel, and food by more than 30% are the results of the inflation launched by the US government to finance the military campaign in Iraq. The war is financed at the expense of the American people and to even greater extend, the people of other world nations since the US dollar is the most commonly used currency for global trade and reserve currency. Because the war has lasted so long, the costs of conducting the operation have ballooned and surpassed the originally budgeted resources leaving the US government with the only option - starting the money press. The shortfall has already reached hundreds of billions of dollars and can only be covered by printing more and more money. The current rise in the global prices is not a result of shrinking supply of recourses (food, oil, etc) or a growing world population. The production volumes as well as the labour component have not changed dramatically and neither did the global consumption. The rise in the global prices is caused exclusively by the inflation of the US dollar. Since the personal incomes in the countries where currencies are tied to the dollar have not changed, the market basket has shrunk by the level of the inflation. As the result, while the people in the industrialized nations are limiting their expenditures on luxury products, the people in the third world are not able to afford the necessities such as food leaving them malnourished or even starving. The discussions whether these processes are the results of structural economic crisis are only partially correct. Such processes normally take decades to develop; current situation is changing in a course of few months to a few years and seems to have started at the same time as the military operation in Iraq. When the inflation started to rapidly rise resulting in higher real estate prices, people rushed to buy houses and apartments since shelter is the most important human priority. Some people bought properties as investment hoping to make money on rising prices. Both types of the buyers used borrowed money to buy the real estate. Now, monthly payment on the loans amount to a considerable sum which warrants re-balancing of households’ budgets and postponing purchases of big ticket items such as cars, furniture, travel, etc. The falling demand for goods and services has lead to job losses for many borrowers who could no longer make payments on their loans. In turn, the banks started to foreclose on the properties but were not able to re-sell them due to the same reason. This was a chain reaction. Further, excess supply of real estate has lead to dramatic reduction in housing construction and supporting industries. One example is forestry since majority of houses in North America are build with wood. All these have started a ‘snow ball’ effecting more and more industries and businesses. Since many companies had also borrowed capital from banks, now they too were failing to make payments on their loans. The result - Financial Credit Crisis. The war in Iraq is not the kind of war that deserves such sacrifices. One tenth of the money spent would have “bought” whole Iraq and ensured a rise of pro-western government in the country. It would be understandable if the war was fought for territories or new markets, but presently there is nothing to fight over since after the collapse of USSR all the eastern block countries became the domain of the west.
Eamon 04 May 10, 19:22	Real reason for the crisis... The crisis is not due to mere mismanagement or financing one war: It has been orchestrated over a very long period, and this is the final raping of the goyim West, before the Money Masters seek to eliminate the useless eaters and (more explicitly) enslave the rest. The solution? Tell the parasitic, private central banks to go to hell -- and start over with a sound, sane monetary system that does not come from the Money Masters.
Eamon 04 May 10, 19:23	Intrinsically evil money system... Our intrinsically evil monetary system is the root of the problem. All "solutions" that fail to address this fact are so much hot air.
18 May 10, 09:05	prez people are so stupid they are not going to tell you whats going on and you need to just beaileve that presidentr are not good and we should all not haVE A PRESIDENT just a GOD PEOPLE ARE STUPID!!!!!!!!!!!!!!!!!!!
Ram babu parihar 24 Jun 10, 03:06	Just not war When the inflation started to rapidly rise resulting in higher real estate prices, people rushed to buy houses and apartments since shelter is the most important human priority. Some people bought properties as investment hoping to make money on rising prices. Both types of the buyers used borrowed money to buy the real estate. Now, monthly payment on the loans amount to a considerable sum which warrants re-balancing of households’ budgets and postponing purchases of big ticket items such as cars, furniture, travel, etc. The falling demand for goods and services has lead to job losses for many borrowers who could no longer make payments on their loans. In turn, the banks started to foreclose on the properties but were not able to re-sell them due to the same reason. This was a chain reaction.
darshan 12 Sep 11, 13:24	Reasons for failure of world economy First is unnecessary productions I mean there is variety of productions for satisfy a need. Need changed through technological innovations but the productions changed with the technological innovation for the market competitiveness. The major problem is starting here. So many investors investing their capital for capturing the market competitiveness but the demand for the same good never increased for their purpose. So there is a market failure for the good and services. However the producers intend the people for the consumptions of their good and services. It means so many substitutions for a satisfaction of a need of the consumers. In the market mechanism the consumers also feel complications about the productions that which is good ? So here we have to mention the production for the people even not the production of the people Here I mention the production for the people, which express technological innovation with the targeting people for the production Here I mention as the 'production of the people' mean the technological innovation with satisfaction of the people So many producers targeting the people for high level of profit,so the cost of productions also high even it is a standard goods or services. So the mechanism of the market giving the reply for it such as Nokia versus Sony Ericsson Sony Ericsson mainly target the satisfaction of the people with small profit and it grownup as long duration even the growth is very smaller past years. But Nokia is the fast company and world famous company. It mainly target the people with the technological innovation and maximize profits. However Nokia handled many ways for getting the world market through advertisement or any variety changes like that Sony Ericsson also handled in a part of this. Anyhow the front Nokia defeated by Sony Ericsson in the market field and I think Sony Ericsson would be still in the field long term rather than Nokia.
darshan 12 Sep 11, 13:27	Reasons for failure However the theory of demand and supply express the old Version.In the contemporary context both theory of demand and supply mislead the suppliers and consumers. Because new theory should explain the mechanism of New Demand and New Supply for the globalization and global integration. However the new theory express the new theory for both supply and demand there must be considered the government role in the root of production and investment on production. However the Demand for good and services depend on the satisfaction and price ,there is an intention to pushes. So the intention should have to consider in the theory of demand as well as theory of supply. Here I mention as an intention that a psychological condition of contemporary context. I know that this is very depth study even it is must and necessity for the present world mechanism. We should mention the virus of the world economy at present because the decisions making for demand and supply are going on for capturing profits even not clearly mention the stand and strong in the market mechanism. The lack of beta between supply and demand in the Global Economy is the major problem for the failure of market mechanism. What to produce and whom to produce are nor clearly decided in the old economic version for the modern society therefore the market failure is must for the contemporary world. Because the resources allocation ,factor endowment,and choice of productions were not clearly expressed by the old versions of economic theories. So we have to consider and correct or create a new theory for the contemporary world mechanism.